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Debunking Beta: Why this risk metric doesn't work.

|Includes: The Procter & Gamble Company (PG)
There is a metric in the financial world called beta that is used as a measurement of the relation between the performance of an individual security or a portfolio and the financial market as a whole. For those who have a firm grasp of this concept please excuse this cursory explanation: a beta equal to 0 has no correlation whatsoever with the market; a negative beta has an inverse relationship with the market; and a positive beta has a positive correlation with the market. By definition the market has a beta of 1 regardless of how volatile it may be. Investors use beta to measure the risk associated with a security or a portfolio. Beta supporters believe that a beta higher than 1 (or lower than -1) implies that an investment inherently riskier. Upon further examination of the issue, I think this metric loses much of its value for any long-term investor.

For starters, beta is a metric based entirely on what can be seen in the rear-view mirror. The historical performance of a company serves as a barometer for what a company is capable of; however, it is by no means a road map to what the future performance of the company will look like. The fact that a stock’s beta can change over time, while the market’s remains the same in spite of its volatility, makes the measurement unreliable. Also, considering that the beta metric only considers performance compared to the broader market completely ignores the possibility that the business might in and of itself be risky irrespective of its demonstrated stock performance. For the sake of argument, consider a company that produces a number of outdoor products for kids. There is no way for beta to consider he risk of any one of the hundreds of different toys that company produces. Individual investors on the other hand might realize the risk inherant in selling in trampolines and or dirt bikes, which while exciting for kids, often lead to injuries that could result from faulty design. 
The use of beta as a proxy for risk gives no indication of upside or downside price movements either. All you know is that there is a statistical risk that price will or won’t move in positive or inverse relation to the broader market. This knowledge is of little value when you are unable to fully quantify the risk associated with the market as a whole! If nothing has changed except an unfortunate (but manageable) event that results in the stock price falling, the stock only becomes more attractive at the lower price. Assuming the problem is in fact manageable, and being handled the right way by a superior management staff, the risk associated with an investment in this company has likely decreased in tandem with the share price.

Let’s use a company like Procter & Gamble (NYSE:PG) as an example. Here is a company with a 3.2% yield, a P/E ratio of 14.6 (3.3% lower than its competitors), and a consistent growth trend over the previous 25 years.  With a beta just under 0.5 this company is considered safe by those who look to beta as a measure of risk. So what happens to the beta of PG if the price of the stock plummets on news of a product recall? Is the investment in PG any riskier this quarter than it was last quarter before the recall was announced? Hardly. Beta, as a quantitative metric, is incapable of accounting for fundamentals. If, prior to the recall, your research led you to believe that management was solid, the growth potential was substantial, and the dividend was attractive, should you assume you made the wrong call because of an unfortunately costly, that is likely a relatively short-term problem?

Strong management and solid growth potential resulting from highly sought after products and services are the true factors that impact risk when investing in a company. If you feel comfortable with these aspects of a company, and you are truly investing in the company as opposed to playing the market, beta is a worthless risk metric. If you are actively trading the stock of a given company, beta is nothing more than a quantitative metric to support your speculative wagers. Either way, beta as a risk metric offers very little in the way of true risk analysis.

Disclosure: No Positions